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Short change - How worried should you be that hedge funds appear so reluctant to short?

20/08/2014

Jamie Lowry

Fund Manager, Equity Value

Towards the start of the year, in Short notice, The Value Perspective referred to a Reuters interview in which Jim Chanos suggested the best time to be going short of markets – a practice in which he has built a reputation as a particularly skilled practitioner – is “when you feel like the village idiot and not an evil genius”.

That latter phrase was a reference to a nickname Chanos has earned over the years as a result of his looking to profit when businesses fail but the general point he was making – and one with which we, as value investors, can empathise is, if you stay true to your preferred investment methodology, then there will inevitably be occasions when you do start to feel a little lonely.

That being the case, Chanos must currently feel as if he is in solitary confinement – not to mention holder of the village idiot of the year 2014 accolade – because, according to an article in the financial times, data compiled by Markit indicates short-selling has fallen to its lowest level in the UK, Europe and the US since Lehman brothers collapsed back in 2008.

Indeed, at around 2%, the percentage of stocks being borrowed by short-sellers in the S&P 500 index in the US is close to the lowest level it has been since Markit started collecting the relevant data in 2006. Now, with market volatility so low, valuations so high and clear evidence of risk-taking right across the board, does that not strike you as strange?

Certainly, as long-only value investors, we are not finding an awful lot to interest us at present and yet hedge funds that are set up specifically to take advantage of downward movements in share prices have apparently decided – to put it politely – to keep their powder dry. Why should this be? Clearly The Value Perspective cannot say for sure but, as ever, we are happy to offer a view.

One possibility is that, niggling away at the back of short-sellers’ minds, is that famous investment warning ‘don’t fight the fed’. The flow of cheap money from the world’s central banks, led by the US Federal Reserve, has helped push markets such as the S&P 500 to record levels and some hedge funds will presumably have had to cut back short positions for the good of their financial health.

In articles such as Electric blues, we have highlighted the hugely inflated valuations of US companies such as electric car manufacturer Tesla, yet in the current environment one would not necessarily want to bet against them growing more inflated still. However, what is more of an observational exercise for value investors – after all, we can just walk away – is a more existential dilemma for the hedge funds.

Another of the world’s better-known short-sellers Greenlight Capital founder David Einhorn sums up the issue thus: “it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly.” In other words, if something you think is egregiously overvalued doubles, it is still egregiously overvalued.

Whatever the underlying explanation, there is clearly a reluctance among the short-sellers of the world to live up to their job description and so almost all investors are currently facing in the same direction. That is reminiscent of one final quote – from former Citigroup boss Chuck Prince, who in 2007 dismissed fears of loose lending standards with the infamous line “as long as the music is playing, you’ve got to get up and dance”. When the music stops though, as Prince found out, the lights tend to come on and everyone can see what you have been up to.

Author

Jamie Lowry

Fund Manager, Equity Value

I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.

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